European Central Bank faces falling inflation with few tools left to stimulate economy

On top of high unemployment and sluggish growth, the European Central Bank has a new headache: an unexpected drop in inflation.

Most people think lower inflation is good news because it makes things easier to buy — and usually it is. But the current slide is just another sign of how weak the economic recovery is in the 17 countries that use the euro.

An official report this week showed a surprise drop in the inflation rate to 0.7 percent in September from 1.1 percent the month before. That's well below the ECB's stated goal of close to but below 2 percent that it considers ideal for the economy.

But the monetary authority for the eurozone may be running short of tools to deal with the problem.


The drop in inflation shows demand is weak: people aren't able or willing to risk spending or borrowing. Sellers can't raise prices as much.

That remains the case in the eurozone, where unemployment is at a record of 12.2 percent and the economy only just emerged from a long recession with anemic growth of 0.3 percent in the second quarter. The worst outcome would be outright deflation. That's an economic death spiral, when a chronic fall in prices leads people to hold off spending because they know goods will become cheaper. Europe is still some distance from that.


The ECB has already used up most of its traditional medicine: lower interest rates. Its benchmark rate — what it charges to loan to banks — is at 0.5 percent, the lowest since the euro was introduced in 1999.

Yet a top ECB council member, Luc Coene of Belgium, has said an unexpected drop in inflation would demand a response.

A few analysts say the ECB might trim the benchmark rate again next week. Howard Archer at IHS Global Insight said the inflation figure had "moved the goal posts" and that a cut was "very much on the agenda." The euro has fallen in the past day, a sign some investors expect the ECB to act.

Others say the ECB is unlikely to be prodded into action by one month's worth of data, since its own inflation forecast isn't due until December.


Besides trimming its benchmark refinancing rate, the ECB could bring its deposit rate — what it pays banks on money they keep with the ECB — below its current level of zero.

That would in theory push banks to stop stashing money at the ECB. But it could also backfire. Banks might simply pass on the cost to customers in the form of higher interest rates. And a negative rate could hurt bank profits at a time when regulators are trying to strengthen banks' finances.


The ECB could also make another long-term offer of cheap credit to banks. Two earlier such offers of just over 1 trillion euros helped stabilize the banking system during the debt crisis.

Yet the banks might simply use the money to buy government bonds instead of lending and stimulating the economy. That would make banks and governments more dependent on each other's finances, a link that helped fuel the financial crisis in the first place.


The ECB could leave more cash in the financial system by not taking weekly interest-bearing deposits from banks. The ECB began taking such deposits when it started buying bonds of indebted countries like Italy and Greece to lower their borrowing costs. The deposits kept the purchases from increasing the supply of money in the economy, and have been allowed to dwindle as the bonds mature. Now that the purchases have stopped, the ECB might stop taking deposits, too.


ECB President Mario Draghi could emphasize the bank's willingness to take more action, such as cut rates. That could cause market interest rates and the euro to drop, which could help keep borrowing cheap and make exports more competitive.

It's uncertain, however, how long markets would respond to all talk and no action.